Morgan Stanley Brokerage Price Looks Cheaper After Profit

By Michael J. Moore -
Jan 19, 2013

Morgan Stanley (MS) may have avoided
paying Citigroup Inc. (C) hundreds of millions of dollars more for
the remaining stake in their Smith Barney joint venture by
fixing a price just before the brokerage’s profit surged.

Morgan Stanley’s wealth-management division, the bulk of
which is the brokerage venture formed in 2009, more than doubled
fourth-quarter net income to $385 million, helping the company
beat analysts’ estimates and sending the stock up 7.9 percent
yesterday. The wealth business surpassed a profit-margin target
six months ahead of schedule.

Morgan Stanley Chief Executive Officer James Gorman and
former Citigroup CEO Vikram Pandit agreed in September to value
the brokerage at $13.5 billion -- fixing the price for a 14
percent stake that Morgan Stanley was buying at the time, and
for the final 35 percent piece. Citigroup had previously
appraised the unit at $22 billion while tagging it for disposal
with other unwanted assets in its Citi Holdings division.

“Morgan Stanley really took them to the cleaners,” said
David Trone, a JMP Securities LLC analyst. “Citi’s decision to
just get it over with was a function of them wanting to get Citi
Holdings closed up as quickly as they could. Personally, I
wouldn’t have sold the last tranche at the same price.”

The joint venture was known as Morgan Stanley Smith Barney
until last year. Its acquisition has built Morgan Stanley’s
wealth-management division into the world’s largest brokerage,
with 16,780 financial advisers at the end of 2012.

The $13.5 billion valuation equated to 9.8 times the
division’s pretax income over the 12 months ended in June. If
that same multiple were placed on 2012 pretax income, the
brokerage’s value would rise to $15.7 billion, driving up the
price for Citigroup’s remaining stake by $770 million. Trone
estimates the brokerage’s true value is more than $20 billion.

Accelerating Purchase

Gorman, 54, announced yesterday that New York-based Morgan
Stanley asked the Federal Reserve for approval to speed up the
purchase of the final piece. He laid out a plan to improve the
company’s return on equity that depends on buying the rest of
the brokerage and improving margins in the business.

“Morgan Stanley is going to be a better version of the old
Merrill Lynch,” once the world’s largest brokerage, said Brad Hintz, an analyst at Sanford C. Bernstein & Co., in a Bloomberg
Radio interview. “Merrill Lynch as a stock outperformed when
the retail investor came flowing back.”

Mark Costiglio, a spokesman at New York-based Citigroup,
and Jim Wiggins at Morgan Stanley declined to comment on the
valuation.

Beating Target

Citigroup’s board of directors ousted Pandit, 56, in
October after concluding that he had mismanaged operations,
causing setbacks with regulators and costing credibility with
investors, a person with knowledge of the discussions said at
the time. Pandit’s oversight of the unit’s valuation contributed
to the decision, according to the person. Before joining
Citigroup, he had spent 22 years at Morgan Stanley.

Morgan Stanley’s wealth-management unit had a pretax margin
of 17 percent in the fourth quarter. The firm previously said it
aimed to reach the “mid-teens” six months from now.

The joint venture’s contract between Citigroup and Morgan
Stanley had called for the brokerage’s value to be calculated as
if it were a public company on the day Morgan Stanley exercised
an option to buy a 14 percent stake. The investment bank invoked
that right on June 1, the day that the Standard & Poor’s 500
Financials Index fell the most last year.

Disappointments, Delays

Perella Weinberg Partners LP, the New York-based investment
bank, was hired to provide an independent appraisal after the
two firms submitted estimates that were more than $13 billion
apart. Perella delivered a valuation below $13.5 billion that
would be used for the 14 percent stake, people with direct
knowledge of the matter said at the time. That sparked a deal
between Gorman and Pandit that raised and locked in the price
for that sale and for the remaining 35 percent.

The negotiations took place after years of disappointment.
Shortly after becoming CEO in 2010, Gorman set pretax margin
goals for the wealth-management division, targeting 15 percent
for that year and 20 percent by the end of 2011. The business
later fell short as the brokerage’s integration took longer than
initially planned. While the banks wrangled over the valuation
last year, brokers complained about glitches and more cumbersome
processes after technology was combined.

Morgan Stanley “took a lot of the pain with struggling
with revenues, trying to get the business fixed, and the stock
being disappointing for shareholders” in the years before the
price was set, said Shannon Stemm, an analyst with Edward Jones
& Co. in St. Louis.

Costs Falling

Annualized revenue per adviser topped $800,000 last
quarter, the first time since the joint venture was formed.
Morgan Stanley also had $3.7 billion of inflows into fee-based
accounts, bringing assets in those accounts to $573 billion, up
$88 billion from a year earlier as the firm makes progress
toward Fleming’s goal of $1 trillion.

Morgan Stanley Chief Financial Officer Ruth Porat, 55, said
the wealth management division’s results were helped by lower-
than-normal compensation costs, which were 57 percent of revenue
instead of the 60 percent investors should expect. At 60
percent, the margin would have been 14 percent.

Still, Trone said the margin will probably continue to
increase to 20 percent as market activity and interest rates
rise.

“We’re starting to see the margin move,” Trone said.
“Two years from now, everyone will be saying what an awesome,
valuable property this is.”